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ExchangeTraded Funds
FOR

DUMmIES

‰

2ND EDITION

by Russell Wild, MBA

Exchange-Traded Funds For Dummies® 2nd Edition
,
Published by
John Wiley & Sons, Inc.
111 River St.
Hoboken, NJ 07030-5774
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Copyright © 2012 by John Wiley & Sons, Inc., Hoboken, New Jersey
Published by John Wiley & Sons, Inc., Hoboken, New Jersey
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About the Author
Russell Wild is a NAPFA-certified financial advisor and principal of Global
Portfolios, an investment advisory firm based in Allentown, Pennsylvania.
He is one of only a handful of wealth managers in the nation who is both feeonly (takes no commissions) and welcomes clients of both substantial and
modest means. He calls his firm Global Portfolios to reflect his ardent belief
in international diversification — using exchange-traded funds to build welldiversified, low-expense, tax-efficient portfolios.
Wild, in addition to the fun he has with his financial calculator, is also an
accomplished writer who helps readers understand and make wise choices
about their money. His articles have appeared in many national publications, including AARP The Magazine, Consumer Reports, Details, Maxim,

Men’s Health, Men’s Journal, Cosmopolitan, Reader’s Digest, and Real Simple.
He writes a regular finance column for The Saturday Evening Post. And he
has also contributed to numerous professional journals, such as Financial
Planning, Financial Advisor, and the NAPFA Advisor.
The author or coauthor of two dozen nonfiction books, Wild’s last work
(prior to the one you’re holding in your hand) was One Year to an Organized
Financial Life, coauthored with professional organizer Regina Leeds, published by Da Capo Press. He also wrote two other Dummies titles in addition
to this one: Bond Investing For Dummies and Index Investing For Dummies.
No stranger to the mass media, Wild has shared his wit and wisdom on such
shows as Oprah, The View, CBS Morning News, and Good Day New York, and
in hundreds of radio interviews.
Wild holds a Master of Business Administration (MBA) degree with a concentration in finance from The Thunderbird School of Global Management,
in Glendale, Arizona (consistently ranked the #1 school for international
business by both U.S. News and World Report and The Wall Street Journal);
a Bachelor of Science (BS) degree in business/economics magna cum
laude from American University in Washington, D.C.; and a graduate certificate in personal financial planning from Moravian College in Bethlehem,
Pennsylvania (America’s sixth-oldest college). A member of the National
Association of Personal Financial Advisors (NAPFA) since 2002, Wild is also a
long-time member and past president of the American Society of Journalists
and Authors (ASJA).
The author grew up on Long Island and now lives in Allentown, Pennsylvania.
His son Clayton attends George Washington University in Washington,
D.C. His daughter Adrienne is in high school. His dog Norman, a standard
poodle, protects their home from killer squirrels. His website is www.global
portfolios.net.



Dedication
To the small investor, who has been bamboozled, bullied, and beaten up long

enough.

Author’s Acknowledgments
Although I’ve written many books, the first edition of this book was my first
Dummies book, and writing a first Dummies book is a bit like learning to ride a
bicycle — on a very windy day. If it weren’t for Joan Friedman, project editor,
who kept a steady hand on the back of my seat, I would surely have fallen off
a curb and been run over by a pickup truck flying a Confederate flag. Joan,
hands down, is one of the best editors I’ve ever worked with. She’s a very
nice person, too. For those reasons, I was absolutely thrilled when I learned
that Joan would be project editor on this second edition, as well. If there’s
ever a third edition . . . Joan?
Other nice people that I’d also like to tip my bicycle helmet to include
Marilyn Allen of Allen O’Shea Literary Agency (she calls me “babe,” just like
agents do in movies; I love that) and Stacy Kennedy, acquisitions editor at
Wiley. If these two gals hadn’t gotten together, I wouldn’t have had a bicycle
to ride.
Thanks, too, to Paul Justice, CFA, editor of Morningstar’s ETFInvestor
newsletter. Paul, who knows a heck of a lot about ETFs, was the official
technical editor on this book, and he checked every chapter to make certain
that this remained strictly a work of nonfiction. Fellow fee-only financial
advisor and good friend Neil Stoloff then double checked. You da man, Neil.
I’d like to thank Morningstar — all the folks there aside from Paul — for
extreme generosity in providing fund industry data and analysis. Additional
good data came from the various ETF providers, such as Vanguard, State
Street, BlackRock, and T. Rowe Price, as well as a few non-ETF providers,
such as Dimensional and the U.S. Treasury. Thanks, all.
I’d also like to thank Donald Bowles, my old professor of economics at
American University, for showing me that supply and demand curves can be
fun. Sorry we lost touch, but I haven’t forgotten you.

And finally, I’d like to thank my old man, attorney Lawrence R. Wild, both
my most beloved and most difficult client, who, if he told me once, told me
a thousand times: ‘Rich or poor, it’s good to have money. It took me years,
Dad, to discover the profound wisdom in that statement.


Publisher’s Acknowledgments
We’re proud of this book; please send us your comments at .
For other comments, please contact our Customer Care Department within the U.S. at 877-762-2974,
outside the U.S. at 317-572-3993, or fax 317-572-4002.
Some of the people who helped bring this book to market include the following:
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Websites

Composition Services

Project Editor: Joan Friedman
Acquisitions Editor: Stacy Kennedy
Assistant Editor: David Lutton
Editorial Program Coordinator: Joe Niesen

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Layout and Graphics: Lavonne Roberts
Proofreaders: Laura Albert, Nancy L. Reinhardt
Indexer: Potomac Indexing, LLC

Technical Editor: Paul Justice
Senior Editorial Manager: Jennifer Ehrlich
Editorial Manager: Carmen Krikorian
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Alexa Koschier
Cover Photos: © iStockphoto.com/
Yong Hian Lim
Cartoons: Rich Tennant
(www.the5thwave.com)
Publishing and Editorial for Consumer Dummies
Kathleen Nebenhaus, Vice President and Executive Publisher
Kristin Ferguson-Wagstaffe, Product Development Director
Ensley Eikenburg, Associate Publisher, Travel
Kelly Regan, Editorial Director, Travel
Publishing for Technology Dummies
Andy Cummings, Vice President and Publisher
Composition Services
Debbie Stailey, Director of Composition Services


Contents at a Glance
Introduction................................................................. 1
Part I: The ABCs of ETFs............................................... 9
Chapter 1: The (Sort of Still) New Kid on the Block..................................................... 11
Chapter 2: What the Heck Is an ETF, Anyway?............................................................. 23
Chapter 3: Getting to Know the Players........................................................................ 45

Part II: Building the Stock (Equity)
Side of Your Portfolio.................................................. 69
Chapter 4: Risk Control, Diversification, and Some Other Things
You Need to Know.......................................................................................................... 71
Chapter 5: Large Growth: Muscular Money Makers..................................................... 91
Chapter 6: Large Value: Counterintuitive Cash Cows................................................ 103
Chapter 7: Small Growth: Sweet Sounding Start-ups................................................. 111

Chapter 8: Small Value: Diminutive Dazzlers.............................................................. 121
Chapter 9: Going Global: ETFs without Borders......................................................... 127
Chapter 10: Sector Investing: ETFs According to Industry....................................... 147
Chapter 11: Specialized Stock ETFs............................................................................. 165

Part III: Adding Bonds, REITs, and
Other ETFs to Your Portfolio....................................... 183
Chapter 12: For Your Interest: The World of Bond ETFs........................................... 185
Chapter 13: Real Estate Investment Trusts (REITs): Becoming
a Virtual Landlord........................................................................................................ 211
Chapter 14: All That Glitters: Gold, Silver, and Other Commodities....................... 219
Chapter 15: Working Non-ETFs and Active ETFs into Your Investment Mix.......... 235

Part IV: Putting It All Together.................................. 249
Chapter 16: Sample ETF Portfolio Menus.................................................................... 251
Chapter 17: Exercising Patience: The Key to Any Investment Success................... 271
Chapter 18: Exceptions to the Rule (Ain’t There Always)......................................... 285
Chapter 19: Using ETFs to Fund Your Golden Years.................................................. 303


Part V: The Part of Tens............................................ 321
Chapter 20: Ten FAQs about ETFs................................................................................ 323
Chapter 21: Ten Mistakes Most Investors (Even Smart Ones) Make....................... 329
Chapter 22: Ten Forecasts about the Future of ETFs and Personal Investing........ 333

Part VI: Appendixes.................................................. 339
Appendix A: Great Web Resources to Help You Invest in ETFs............................... 341
Appendix B: Glossary..................................................................................................... 347

Index....................................................................... 353

Table of Contents
Introduction.................................................................. 1
Since the First Edition . . ................................................................................. 1
Out of the shadows................................................................................. 2
Filling the investment voids.................................................................. 2
Creations of dubious value.................................................................... 2
Morphing into new creatures................................................................ 3
About This Book............................................................................................... 3
Conventions Used in This Book...................................................................... 5
What You’re Not to Read................................................................................. 5
Foolish Assumptions........................................................................................ 6
How This Book Is Organized........................................................................... 6
Part I: The ABCs of ETFs........................................................................ 6
Part II: Building the Stock (Equity) Side of Your Portfolio................ 6
Part III: Adding Bonds, REITs, and Other ETFs to Your Portfolio..... 7
Part IV: Putting It All Together.............................................................. 7
Part V: The Part of Tens......................................................................... 7
Part VI: Appendixes................................................................................ 7
Icons Used in This Book.................................................................................. 7
Where to Go from Here.................................................................................... 8

Part I: The ABCs of ETFs................................................ 9
Chapter 1: The (Sort of Still) New Kid on the Block . . . . . . . . . . . . . . . 11
In the Beginning.............................................................................................. 11
Enter the traders................................................................................... 12
Moving south of the border................................................................. 12
Fulfilling a Dream............................................................................................ 13
Goodbye, ridiculously high mutual fund fees................................... 13

Hello, building blocks for a better portfolio...................................... 14
Will you miss the court papers?......................................................... 14
Not Quite as Popular as the Beatles, But Getting There........................... 15
Moving from Wall Street to Main Street............................................. 16
Keeping up with the Vanguards.......................................................... 16
Ready for Prime Time.................................................................................... 18
The proof of the pudding..................................................................... 19
The major players................................................................................. 20
Twist and shout: Commercialization is tainting a good thing........ 21

Chapter 2: What the Heck Is an ETF, Anyway? . . . . . . . . . . . . . . . . . . . 23
The Nature of the Beast................................................................................. 23
Choosing between the Classic and the New Indexes................................. 25


x

Exchange-Traded Funds For Dummies, 2nd Edition
Preferring ETFs over Individual Stocks....................................................... 26
Distinguishing ETFs from Mutual Funds...................................................... 27
Why the Big Boys Prefer ETFs...................................................................... 28
Trading in large lots............................................................................. 28
Savoring the versatility........................................................................ 28
Why Individual Investors Are Learning to Love ETFs................................ 29
The cost advantage: How low can you go?........................................ 30
Uncle Sam’s loss, your gain................................................................. 32
What you see is what you get.............................................................. 35
Getting the Professional Edge....................................................................... 37
Consider a few impressive numbers.................................................. 37
You can do what they do!.................................................................... 38

Passive versus Active Investing: Your Choice............................................ 38
The index advantage............................................................................ 38
The allure of active management....................................................... 39
Why the race is getting harder to measure . . . and what to do
about it............................................................................................... 40
Do ETFs Belong in Your Life?........................................................................ 41
Calculating commissions..................................................................... 41
Moving money in a flash...................................................................... 41
Understanding tracking error............................................................. 41
Making a sometimes tricky choice..................................................... 42

Chapter 3: Getting to Know the Players . . . . . . . . . . . . . . . . . . . . . . . . . 45
Creating an Account for Your ETFs.............................................................. 45
Answering a zillion questions............................................................. 46
Placing an order to buy........................................................................ 48
But wait just a moment!....................................................................... 49
Trading ETFs like a pro........................................................................ 49
Introducing the Shops.................................................................................... 50
What to look for.................................................................................... 50
A price structure like none other....................................................... 51
The Vanguard Group............................................................................ 51
Fidelity Investments............................................................................. 52
Charles Schwab..................................................................................... 53
T. Rowe Price......................................................................................... 53
TD Ameritrade....................................................................................... 53
Scottrade................................................................................................ 54
Other brokerage houses...................................................................... 54
Presenting the Suppliers................................................................................ 55
It’s okay to mix and match – with caution......................................... 55
Check your passport............................................................................ 57

BlackRock iShares................................................................................. 57
State Street Global Advisers (SSgA) SPDRs....................................... 58
Vanguard ETFs...................................................................................... 58
Invesco PowerShares........................................................................... 60
ProShares............................................................................................... 60
Van Eck (Market Vectors ETFs).......................................................... 61
WisdomTree.......................................................................................... 61


Table of Contents
Guggenheim........................................................................................... 62
Other suppliers..................................................................................... 63
Familiarizing Yourself with the Indexers..................................................... 63
Standard & Poor’s................................................................................. 64
Dow Jones.............................................................................................. 64
MSCI........................................................................................................ 64
Russell.................................................................................................... 65
Barclays.................................................................................................. 65
Meeting the Middlemen................................................................................. 65
NYSE Arca.............................................................................................. 66
NASDAQ................................................................................................. 66
Meeting the Wannabe Middlemen................................................................ 67
Commissioned brokers........................................................................ 67
Separately managed accounts (SMAs)............................................... 67
Annuities and life insurance products............................................... 68
Mutual funds of ETFs............................................................................ 68

Part II: Building the Stock (Equity)
Side of Your Portfolio................................................... 69
Chapter 4: Risk Control, Diversification, and Some Other

Things You Need to Know . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
Risk Is Not Just a Board Game...................................................................... 72
The trade-off of all trade-offs (safety versus return)....................... 72
So just how risky are ETFs?................................................................. 73
Smart Risk, Foolish Risk................................................................................. 74
How Risk Is Measured.................................................................................... 76
Standard deviation: The king of all risk measurement tools........... 76
Beta: Assessing price swings in relation to the market................... 78
The Sharpe, Treynor, and Sortino ratios: Measures of
what you get for your risk................................................................ 79
Meet Modern Portfolio Theory..................................................................... 81
Tasting the extreme positivity of negative correlation................... 81
Settling for limited correlation............................................................ 83
Reaching for the elusive Efficient Frontier........................................ 84
Accusations that MPT is dead are greatly exaggerated.................. 85
Mixing and Matching Your Stock ETFs........................................................ 86
Filling in your style box........................................................................ 86
Buying by industry sector................................................................... 88
Don’t slice and dice your portfolio to death..................................... 89

Chapter 5: Large Growth: Muscular Money Makers . . . . . . . . . . . . . . 91
Style Review.................................................................................................... 93
What makes large cap large?............................................................... 93
How does growth differ from value?.................................................. 93
Putting these terms to use................................................................... 94

xi


xii

Exchange-Traded Funds For Dummies, 2nd Edition
Big and Brawny............................................................................................... 94
Contrary to all appearances . . ........................................................... 95
Let history serve as only a rough guide............................................. 95
ETF Options Galore........................................................................................ 96
Strictly large cap or blend?.................................................................. 96
Blended options for large cap exposure............................................ 98
Strictly large growth........................................................................... 100
ETFs I wouldn’t go out of my way to own........................................ 102

Chapter 6: Large Value: Counterintuitive Cash Cows . . . . . . . . . . . . . 103
Six Ways to Recognize Value....................................................................... 104
Looking for the Best Value Buys................................................................. 106
Taking the index route....................................................................... 106
Making an ETF selection.................................................................... 107

Chapter 7: Small Growth: Sweet Sounding Start-ups . . . . . . . . . . . . 111
Getting Real about Small Cap Investments............................................... 112
Your Choices for Small Growth.................................................................. 113
Small cap blend funds........................................................................ 114
Strictly small cap growth funds........................................................ 116
Smaller than Small: Meet the Micro Caps.................................................. 118

Chapter 8: Small Value: Diminutive Dazzlers . . . . . . . . . . . . . . . . . . . . 121
It’s Been Quite a Ride................................................................................... 123
Latching on for fun and profit........................................................... 123
But keeping your balance.................................................................. 123
What About the Mid Caps?.......................................................................... 126

Chapter 9: Going Global: ETFs without Borders . . . . . . . . . . . . . . . . . 127
The Ups and Downs of Different Markets around the World.................. 128
Low correlation is the name of the game........................................ 129
Remember what happened to Japan................................................ 130
Finding Your Best Mix of Domestic and International............................. 130
Why putting two-thirds of your portfolio in foreign
stocks is too much.......................................................................... 131
Why putting one-fifth of your portfolio in foreign
stocks is insufficient....................................................................... 132
Why ETFs are a great tool for international investing................... 133
Not All Foreign Nations — or Stocks — Are Created Equal.................... 134
Choosing the Best International ETFs for Your Portfolio........................ 136
Four brands to choose from.............................................................. 136
All the world’s your apple: ETFs that cover the planet................. 137
European stock ETFs: From the North Sea to the
shores of the Mediterranean......................................................... 138
Pacific region stock ETFs: From Mt. Fuji to that
big island with the kangaroos........................................................ 140


Table of Contents
Emerging-market stock ETFs: Well, we hope
that they’re emerging..................................................................... 142
iShares value and growth: Two special ETFs
for style investing abroad.............................................................. 144
Small cap international: Yes, you want it........................................ 145

Chapter 10: Sector Investing: ETFs According to Industry . . . . . . . . 147
Selecting Stocks by Sector, not Style......................................................... 148
Speculating on the Next Hot Industry........................................................ 150

Sizzling and sinking............................................................................ 150
Momentum riders and bottom feeders............................................ 150
Doing Sector Investing Right....................................................................... 151
Calculating your optimal sector mix................................................ 151
Seeking risk adjustment with high and low volatility sectors...... 152
Knowing where the style grid comes through................................ 153
Combining strategies to optimize your portfolio........................... 154
Seeking low correlations for added diversification........................ 154
Sector Choices by the Dozen...................................................................... 155
Vanguard ETFs.................................................................................... 156
Select Sector SPDRs: State Street Global Advisors (Part I)........... 157
SPDRs: State Street Global Advisors (Part II).................................. 158
BlackRock’s iShares............................................................................ 160
PowerShares........................................................................................ 161

Chapter 11: Specialized Stock ETFs . . . . . . . . . . . . . . . . . . . . . . . . . . . .165
Investing for a Better World........................................................................ 166
Tracking the history of SRI performance......................................... 166
Your growing number of choices for social investing................... 167
A close-up look at your SRI options................................................. 168
Dividend Funds: The Search for Steady Money........................................ 170
Your high dividend ETF options....................................................... 170
Promise of riches or smoke and mirrors?....................................... 171
Investing in Initial Public Offerings............................................................ 174
The rollercoaster of recent IPO performance................................. 174
Taking a broader look at IPOs........................................................... 175
Funds That (Supposedly) Thrive When the Market Takes a Dive......... 175
Entering an upside-down world........................................................ 176
Boasting a track record like none other.......................................... 177
Funds That Double the Thrill of Investing (for Better or Worse)........... 177

Crazy math: Comparing leveraged funds to traditional ETFs....... 178
Examining a rather pathetic track record....................................... 179
All-In-One ETFs: For the Ultimate Lazy Portfolio...................................... 180
Getting worldwide exposure to stocks and bonds......................... 180
Russell’s average review for the average reader
on an average day........................................................................... 182

xiii


xiv

Exchange-Traded Funds For Dummies, 2nd Edition

Part III: Adding Bonds, REITs, and Other
ETFs to Your Portfolio................................................ 183
Chapter 12: For Your Interest: The World of Bond ETFs . . . . . . . . . . . 185
Tracing the Track Record of Bonds........................................................... 186
Portfolio protection when you need it most................................... 188
History may or may not repeat......................................................... 189
Tapping into Bonds in Various Ways......................................................... 190
Finding strength in numbers............................................................. 191
Considering bond fund costs............................................................ 191
Casting a wide net............................................................................... 192
Sampling Your Basic Bond-ETF Menu........................................................ 192
Tapping the Treasurys: Uncle Sam’s IOUs...................................... 193
Gas at $5.00 a gallon? Getting inflation protection in a flash........ 196
Banking on business: Corporate bond ETFs................................... 197
The whole shebang: Investing in the entire U.S. bond market..... 199
Moving Beyond Basics into Municipal and Foreign Bonds..................... 201

Municipals for mostly tax-free income............................................. 202
Foreign bonds for fixed-income diversification.............................. 203
Emerging-market bonds: High risk, high return.............................. 205
Determining the Optimal Fixed Income Allocation.................................. 206
60/40? 50/50? Finding a split that makes sense............................... 207
Meet Joe, age 67, with a little more than $600,000 in the bank..... 208
Meet Betsy and Mike, age 36, with $30,000 in the bank................. 209

Chapter 13: Real Estate Investment Trusts (REITs):
Becoming a Virtual Landlord . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211
Considering Five Distinguishing Characteristics of REITs...................... 212
Limited correlation to the broad markets....................................... 212
Unusually high dividends.................................................................. 213
Different taxation of dividends......................................................... 213
Special status among financial pros................................................. 213
Connection to tangible property...................................................... 214
Calculating a Proper REIT Allocation......................................................... 214
Judging from the past......................................................................... 214
Splitting the baby: Domestic and international REIT funds.......... 215
Picking REIT ETFs for Your Portfolio......................................................... 216
U.S. domestic REIT ETFs.................................................................... 217
Global REIT funds............................................................................... 218

Chapter 14: All That Glitters: Gold, Silver, and Other
Commodities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219
Gold, Gold, Gold!........................................................................................... 220
Midas touch or fool’s gold?............................................................... 221
A vastly improved way to buy the precious metal......................... 222
The tax man cometh........................................................................... 223

Table of Contents
Silver: The Second Metal............................................................................. 223
Quick silver on the move................................................................... 223
If you must . . ...................................................................................... 224
Oil and Gas: Truly Volatile Commodities.................................................. 225
Oily business....................................................................................... 225
No experience necessary................................................................... 226
The sad saga of contango.................................................................. 226
Taxing your tax advisor..................................................................... 227
(Somewhat) Safer Commodity Plays.......................................................... 228
General commodity index funds....................................................... 228
Actively managed, or quasi-actively managed,
commodity funds............................................................................ 230
Awaiting new developments............................................................. 231
Playing the Commodity Market Indirectly................................................ 231
Tapping into commodity companies............................................... 232
Tapping into commodity-rich countries.......................................... 234

Chapter 15: Working Non-ETFs and Active ETFs
into Your Investment Mix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235
Tinkering with an Existing Stock or Mutual Fund Portfolio.................... 236
Improving your diversification......................................................... 236
Minimizing your investment costs................................................... 237
Using ETFs to tax harvest.................................................................. 238
Looking Beyond the Well-Rounded ETF Portfolio.................................... 239
Mutual funds as cheap as ETFs: Vanguard Admiral shares.......... 239
Where few investors have gone before: DFA funds........................ 240
Timber REITs....................................................................................... 241
I Bonds: An Uncle Sam bond with a twist........................................ 242

Market-neutral mutual funds............................................................. 242
A commodity fund without too much hassle.................................. 243
Fixed immediate annuities................................................................. 244
Venturing into exchange-traded notes............................................. 244
Going Active with ETFs................................................................................ 246

Part IV: Putting It All Together.................................. 249
Chapter 16: Sample ETF Portfolio Menus . . . . . . . . . . . . . . . . . . . . . . . 251
So, How Much Risk Can You Handle and Still Sleep at Night?................ 252
A few things that just don’t matter................................................... 253
The irony of risk and return.............................................................. 254
The 20x rule......................................................................................... 254
Other risk/return considerations..................................................... 256
The limitations of risk questionnaires............................................. 256
Keys to Optimal Investing........................................................................... 258
Incorporating Modern Portfolio Theory into
your investment decisions............................................................. 258
Minimizing your costs........................................................................ 258

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Striving for tax efficiency................................................................... 259
Timing your investments (just a touch).......................................... 259
Finding the Perfect Portfolio Fit.................................................................. 260
Considering the simplest of the simple........................................... 260
Racing toward riches: A portfolio that may require

a crash helmet................................................................................. 261
Sticking to the middle of the road.................................................... 263
Taking the safer road: Less oomph, less swing.............................. 267

Chapter 17: Exercising Patience: The Key to
Any Investment Success . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 271
The Tale of the Average Investor (A Tragicomedy in One Act)............. 274
Returns that fall way short of the indexes....................................... 274
ETFs can make failure even easier!................................................... 275
The lure of quick riches..................................................................... 276
The Value Line Paradox............................................................................... 277
Paper versus practice........................................................................ 277
The lesson to be learned................................................................... 278
“Investment Pornography” in Your Mailbox (and Mine)......................... 278
Welcome to the wild, wacky world of investment advice............. 279
Caveat emptor: ETF-trading websites for suckers.......................... 280
Patience Pays, Literally................................................................................ 281
Talk about unpredictability............................................................... 281
A short history of the market’s resiliency....................................... 282

Chapter 18: Exceptions to the Rule (Ain’t There Always) . . . . . . . . . 285
Rebalancing to Keep Your Portfolio Fit..................................................... 286
How rebalancing works...................................................................... 286
How often to rebalance...................................................................... 288
Rebalancing for retirees..................................................................... 288
Contemplating Tactical Asset Allocation.................................................. 289
Understanding the all-important P/E ratio...................................... 289
Applying the ratio to your portfolio................................................. 290
Buying unloved assets....................................................................... 291
Investing the SweetSpot way............................................................. 291

Harvesting Tax Losses, and the IRS’s Oh-So-Tricky “Wash Rule”.......... 293
What the heck is “substantially identical” anyway?....................... 293
As always, consider cost.................................................................... 294
Revamping Your Portfolio with Life Changes:
Marriage, Divorce, and Babies................................................................ 294
Betsy and Mark: A fairly typical couple........................................... 295
One year later...................................................................................... 296
Yet one year later............................................................................... 297
Are Options an Option for You?................................................................. 297
Understanding puts and calls........................................................... 298
Using options to make gains without risk....................................... 299
Insuring yourself against big, bad bears.......................................... 300


Table of Contents
Seeming almost too good to be true................................................ 300
Weighing options strategies against the diversified
ETF portfolio.................................................................................... 301
Factoring in time and hassle............................................................. 301

Chapter 19: Using ETFs to Fund Your Golden Years . . . . . . . . . . . . . . 303
Aiming for Economic Self-Sufficiency......................................................... 304
Taking the basic steps........................................................................ 305
Choosing the right vessels................................................................ 305
Curing the 401(k) Blues............................................................................... 309
Lobbying the benefits manager........................................................ 310
Introducing the Roth 401(k).............................................................. 312
Strategies for the Self-Employed................................................................. 314
The traditional IRA versus the Roth IRA.......................................... 314
Taxes now or taxes later?.................................................................. 315

Ushering Your Portfolio into Retirement Readiness................................ 315
15+ years and counting...................................................................... 315
Less than 15 years to retirement...................................................... 316
Withdrawing Funds to Replace Your Paycheck........................................ 316
Don’t obsess over maintaining principal or
drawing from dividends................................................................. 317
As always, watch the fees.................................................................. 319
Take your minimum required distributions.................................... 319
IRA, 401(k), or regular (taxable) brokerage account:
Which to tap first?........................................................................... 320

Part V: The Part of Tens............................................. 321
Chapter 20: Ten FAQs about ETFs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323
Are ETFs Appropriate for Individual Investors?....................................... 323
Are ETFs Risky?............................................................................................. 323
Do I Need a Financial Professional to Set Up and Monitor an ETF
Portfolio?.................................................................................................... 324
How Much Money Do I Need to Invest in ETFs?....................................... 325
With Hundreds of ETFs to Choose From, Where Do I Start?................... 325
Where Is the Best Place for Me to Buy ETFs?........................................... 326
Is There an Especially Good or Bad Time to Buy ETFs?.......................... 326
Do ETFs Have Any Disadvantages?............................................................ 326
Does It Matter Which Exchange My ETF Is Traded On?.......................... 327
Which ETFs Are Best in My IRA, and Which Are
Best in My Taxable Account?.................................................................. 327

Chapter 21: Ten Mistakes Most Investors
(Even Smart Ones) Make . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329
Paying Too Much for an Investment.......................................................... 329
Failing to Properly Diversify........................................................................ 329

Taking on Inappropriate Risks.................................................................... 330

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Selling Out When the Going Gets Tough................................................... 330
Paying Too Much Attention to Recent Performance............................... 330
Not Saving Enough for Retirement............................................................. 331
Having Unrealistic Expectations of Market Returns................................ 331
Discounting the Damaging Effect of Inflation............................................ 332
Not Following the IRS’s Rules...................................................................... 332
Failing to Incorporate Investments into a Broader Financial Plan......... 332

Chapter 22: Ten Forecasts about the Future of ETFs
and Personal Investing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333
ETF Assets Will Continue to Grow . . . for Better or Worse..................... 333
More Players May Enter the Field, but Only a Few.................................. 334
Investors Will Get Suckered into Buying Packaged Products................. 334
ETF Investors Will Have More, and Better, Options................................ 335
The Markets Will (Unfortunately) See Greater Correlation
than in the Past......................................................................................... 335
Asset Class Returns Will Revert toward Their Historic Means.............. 336
Taxes Will Rise.............................................................................................. 336
Inflation Will Remain Tame......................................................................... 337
Private Pensions (of Sorts) May Emerge from the Rubble...................... 337
Hype Will Prevail!.......................................................................................... 338

Part VI: Appendixes................................................... 339
Appendix A: Great Web Resources to Help You Invest in ETFs . . . . 341
Appendix B: Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 347

Index........................................................................ 353


Introduction

E

very month, it seems, Wall Street comes up with some newfangled
investment idea. The array of financial products (replete with 164-page
prospectuses) is now so dizzying that the old lumpy mattress is starting to
look like a more comfortable place to stash the cash. But there is one relatively new product out there definitely worth looking at. It’s something of a
cross between an index mutual fund and a stock, and it’s called an exchangetraded fund, or ETF.
Just as computers and fax machines were used by big institutions before
they caught on with individual consumers, so it was with ETFs. They were
first embraced by institutional traders — investment banks, hedge funds, and
insurance firms — because, among other things, they allow for the quick juggling of massive holdings. Big traders like that sort of thing. Personally, playing hot potato with my money is not my idea of fun. But all the same, over
the past several years, I’ve invested most of my own savings in ETFs, and I’ve
suggested to many of my clients that they do the same.
I’m not alone in my appreciation of ETFs. They have grown exponentially in
the past few years, and they will surely continue to grow and gain influence.
While I can’t claim that my purchases and my recommendations of ETFs
account for much of the growing $1 trillion+ ETF market, I’m happy to be
a (very) small part of it. After you’ve read this second edition of ExchangeTraded Funds For Dummies, you may decide to become part of it as well, if
you haven’t already.

Since the First Edition . . .

Many changes have taken place in the investment world, both on Wall Street
and Main Street, since the first edition of this book was published in 2007. For
one thing, a much larger pot of money is now invested in ETFs: $1.1 trillion as
of this writing (up from a mere $300 billion in 2007). Also, when I introduce
myself as the author of Exchange-Traded Funds For Dummies, I no longer get a
look as if I’m speaking some strange language with a lisp. Many people today,
perhaps most, are at least somewhat familiar with the term exchange-traded
funds. ETFs have, after all, made a few headlines.


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Exchange-Traded Funds For Dummies, 2nd Edition

Out of the shadows
The rising popularity of ETFs has been a news story in and of itself. Many
educated folks are now aware that ETFs are low-cost investment vehicles that
can serve as building blocks for a diversified portfolio.
But ETFs have gotten a bad rap, too, especially for the role they played in
the infamous “flash crash” of May 6, 2010 (see Chapter 2) and for the ongoing
role they are playing in the increasingly nauseating volatility of the markets.
According to one 2010 report from the Ewing Marion Kauffman Foundation,
“ETFs are choking the recovery and may pose unrecognized risks to the
financial markets.”
Well, I’m not so sure about that (especially given that the stock market shot
up 10 percent in the six months immediately following the Kauffman report). I
discuss the overall effect that ETFs have had on financial markets, but what I
concentrate on most in this second edition is how changes in the ETF market
affect you — the individual investor. And in that arena, without question,
there have been many changes both positive and negative.

Filling the investment voids
One very positive change in the past several years is that the “black holes”
that I identified in the first edition of this book have largely been filled. That
is, half a decade ago, you could not buy an ETF that would give you exposure
to tax-free municipal or high-yield bonds. Or international bonds. Or international REITs. All that has changed. There are now ETFs that represent all
those asset classes, and many more. Building an entire well-diversified portfolio out of ETFs was not humanly possible several years ago; it is very possible today. I’ve done it numerous times!
Another very positive development: ETFs have recently been making a grand
entrance into employer-sponsored 401(k) plans, where many of America’s
hard-working people store the bulk of their savings. And they’ve been appearing lately in college-saving 529 plans, too. Insurance companies have also
jumped into the fray, offering ETFs in some of their annuity plans (which,
unfortunately, are still often overpriced).

Creations of dubious value
Many of the newer ETFs are bad investments, pure and simple. They were
introduced to take advantage of the popularity of ETFs. They are overly
expensive, and they represent foolish indexes (extremely small segments of
the market, or indexes constructed using highly questionable methodologies). Much of this book is designed to help you tell the good from the bad.


Introduction
Many of the newer ETFs are also specifically designed for short-term
trading — which you would know if you read the really small print at the bottom of the
advertisements — and short-term trading usually gets small investors into big
trouble.
A scary number of the newer ETFs are based on “back-tested” models: They
track whatever indexes, or invest in whatever kinds of assets, have done
the best in recent months or years. These ETFs (or the indexes they track)
have shining short-term performance records, which induce people to buy.
But past short-term performance is a very, very poor indicator of future

performance.

Morphing into new creatures
Actively managed ETFs have been slower to take off than Wall Street had
hoped but have made inroads since the first edition of this book. These ETFs
differ radically from the original index ETFs. Actively managed ETFs don’t
track any indexes at all but instead have portfolios built and regularly traded
by managers attempting to beat the indexes. Active management, study
after study has shown, usually doesn’t work all that well for investors, even
though the managers themselves often get very rich (more in Chapter 2).
And finally, many of the newer exchange-traded products aren’t ETFs at all
but very different financial instruments called exchange-traded notes (ETNs).
ETNs aren’t bad, per se, but they represent risks that ETFs do not . . . and
that too few people understand (see my discussion in Chapters 14 and 15).

About This Book
As with any other investment, you’re looking for a certain payoff in reading
this book. In an abstract sense, the payoff will come in your achieving a thorough understanding and appreciation of a powerful financial tool called an
exchange-traded fund. The more concrete payoff will come when you apply
this understanding to improve your investment results.
What makes me think ETFs can help you make money?


✓ETFs are intelligent. Most financial experts agree that playing with
individual stocks can be hazardous to one’s wealth. Anything from an
accounting scandal to the CEO’s sudden angina attack can send a single
stock spiraling downward. That’s why it makes sense for the average
investor to own lots of stocks — or bonds — through ETFs or mutual
funds.

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Exchange-Traded Funds For Dummies, 2nd Edition


✓ETFs are cheap. At least 150 ETFs charge annual management expenses
of 0.20 percent or lower, and a few charge as little as 0.06 percent a year.
The average actively managed mutual fund, in contrast, charges 1.33
percent a year. Index mutual funds generally cost a tad more than their
ETF cousins. Such cost differences, while appearing small on paper, can
make a huge impact on your returns over time. I crunch some appropriate numbers in Chapter 2.



✓ETFs are tax-smart. Because of the very clever way ETFs are structured,
the taxes you pay on any growth are minimal. I crunch some of those
numbers as well in Chapter 2.



✓ETFs are open books. Quite unlike mutual funds, an ETF’s holdings are
readily visible. If this afternoon, for example, I were to buy 100 shares of
the ETF called the SPDR (pronounced “spider”) S&P 500, I would know
that exactly 3.44 percent of my money was invested in Exxon Mobil
Corp, 2.59 percent was invested in Apple, Inc., and 1.77 percent was
invested in General Electric Co. You don’t get that kind of detail when
you buy most mutual funds. Mutual fund managers, like stage magicians,

are often reluctant to reveal their secrets. In the investment game, the
more you know, the lower the odds you will get sawed in half.

(News flash: Regulators are still debating just how open the portfolios
of the newer actively managed ETFs will have to be. For the time being,
however, most ETFs track indexes, and the components of any index are
readily visible.)
And speaking of open books, if the one you’re now reading were like some
(but certainly not all) mutual funds, it would be largely unintelligible and
expensive. (It might be doubly expensive if you tried to resell the book within
90 days!) Luckily, this book is more like an ETF. Here’s how:


✓Exchange-Traded Funds For Dummies is intelligent. I don’t try to
convince you that ETFs are your best investment choice, and I certainly
don’t tell you that ETFs will make you rich. Instead, I lay out facts and
figures and summarize some hard academic findings, and I let you draw
your own conclusions.



✓Exchange-Traded Funds For Dummies is cheap. Hey, top-notch investment advice for only $26.99 (plus or minus any discounts, shipping, and
tax) . . . Where else are you going to get that kind of deal? And should you
come to the conclusion after reading this book that ETFs belong in your
portfolio, you’ll likely get your $26.99 (plus any shipping costs and tax)
back — in the form of lower fees and tax efficiency — in no time at all.



✓Exchange-Traded Funds For Dummies is tax-smart. Yes, the money

you spent for this book, as all other outlays you make for investment
advice, may be deducted from your federal income taxes (provided you
itemize your deductions). Go for it!



✓Exchange-Traded Funds For Dummies is an open book. We’ve already
established that!


Introduction
If you’ve ever read a For Dummies book before, you have an idea of what you’re
about to embark on. This is not a book you need to read from front to back. Feel
free to jump about and glean whatever information you think will be of most use.
There is no quiz at the end. You don’t have to commit it all to memory.

Conventions Used in This Book
To help you navigate this text as easily as possible, I use the following
conventions:


✓Whenever I introduce a new term, it appears in italic. You can rest
assured that I provide a definition or explanation nearby.



✓If I want to share some interesting information that isn’t crucial to your
understanding of the topic at hand, I place it in a sidebar, a gray box with
its own heading that is set apart from the rest of the text. (See how this
whole italic/definition thing works?)

✓All website addresses appear in monofont so they’re easy to pick out if
you need to go back and find them.
Keep in mind that when this book was printed, some web addresses may
have needed to break across two lines of text. If that happened, rest assured
that we haven’t put in any extra characters (such as hyphens) to indicate the
break. So, when using one of these web addresses, just type in exactly what
you see in this book, pretending as though the line break doesn’t exist.

What You’re Not to Read
When my computer is ill, and I call “Tom” (Dell’s man somewhere in India or
the Philippines), all I want is for Tom to fix my problem, whatever that is. I’m
not in the market for explanations. On the ETF front, however, I really like
knowing all the technical ins and outs. That may not be your thing. You may
be like me with my computer problems: “Just tell me how to make money
with these things, and keep the technical stuff to yourself, Russ.” Okay, I do
that. Sort of.
Throughout this book, you usually find the heavy technical matter tucked
neatly into sidebars. But if any technicalities make it into the main text, I give
you a heads up with a Technical Stuff icon so you can skip over that section,
or just speed-read it if you wish.

5